JeremyRepanich.com » Derivatives

Hedgers Brace for Hurricane Season

admin — Thu, 04 Jun 2009 21:32:41 +0000

With the Atlantic hurricane season getting underway this week, rising temperatures and wind speeds on the Eastern Seaboard and Gulf Coast could give way to rising trade volumes for the Chicago-based CME Group Inc. for hurricane derivatives.

Last year 32,600 contracts were cleared through the CME, most of which were traded during the hurricane season. So far this year 4,000 contracts were traded in January and more are expected to be exchanged as the hurricane season progresses.

At the present, hurricane derivatives are a small player in the market, said Bill Bergman, an insurance industry analyst with Morningstar Inc., adding that there is potential for the contracts to become more popular.

“It’s an exciting product that could fill a very substantial niche down the road,” he said.

Born in the wake of the destructive hurricane season of 2005, the contracts were conceived as a solution to some of the problems arising from hurricanes, namely, the time it takes for insurance claims to be paid after one occurs, said Steve Smith, senior vice president at Willis Re, the reinsurance arm of global insurance broker Willis Holdings Group Ltd. That delay could prove to be detrimental to a company, which needs the money to resume normal operations.

“If I’m running a business, I may have to pay for repairs out of pocket and it may take upwards of a year before I get insurance money,” said Felix Carabello, director of alternative investments at CME.

Delays occur because insurance and reinsurance companies take time to assess losses caused by a storm. That led Smith to find a way to peg the payout for a hurricane not to damage it causes but to its strength and destructive potential.

“They were looking for an index that captures hurricane risk but at the same time you don’t have to wait 24 months,” he said.

However, Smith, while working at Carvill America Inc., found that classifying a hurricane using the metric commonly cited by the media, the Saffir-Simpson Scale, which rates a storm’s strength on a scale of one to five, failed to provide an accurate measure of a hurricane’s potential for damage.

Utilizing research done at the University of Colorado, Smith created the Carvill Hurricane Index, now called the CME Hurricane Index after CME purchased it in April. The CHI calculates the potential for damage from a storm by using National Weather Service data regarding the wind speed and radius of a hurricane.

The index more accurately assessed the strength of Hurricane Katrina than did the Saffir-Simpson Scale. For example, the Saffir-Simpson Scale rated Hurricane Wilma stronger than Hurricane Katrina, whereas the index more accurately captured that Katrina was a potentially more destructive storm.

Armed with that accuracy, it was then possible to incorporate storms into a tradable hurricane futures contract. CME began clearing the contracts, which allow a company to hedge against the risk posed by either an individual hurricane or an entire season.

If a company decides it needs additional coverage in the event of a storm or, in the case of an insurance company, wants to offset some of the risk of holding several insurance contracts in areas susceptible to hurricanes, it can find a party willing to enter into a hurricane contract. The company looking to offset its risk will decide how strong of a storm on the CME Hurricane Index it could withstand and then seek a contract that would pay out the desired amount of coverage if the hurricane was stronger than that when it made landfall.

For a company to receive $10 million of coverage on a CHI 15 storm in Florida, currently that company would have to pay 15 percent to 17 percent or $1.5 million to $1.7 million, according to Steve Breen, executive vice president at Tradition Re LLC, which brokers hurricane contracts.

If the storm makes landfall and is a15 on the CME Hurricane Index, the company that bought the coverage will receive the $10 million in two days instead of the two years it make take for insurance companies to pay. If the storm makes landfall below a15, the company is out the premium it paid.

While the primary users of hurricane contracts are reinsurance companies and hedge funds, the derivatives could gain a foothold in other industries susceptible to large-scale impact from hurricanes.

“Where I think this has real legs is the oil and energy and gas markets, once they see liquidity and volume this will be a brilliant way to hedge risk,” said Breen said.

Big storms could mean big losses for companies with refineries or oil platforms in the Gulf Coast region. While traditional insurance could help cover the damage incurred to a refinery or offshore oil platform, a hurricane derivative could be purchased to also cover money lost because of a decline in production if a large storm hits.

At the present, hurricane derivatives are a small player in the market right now, Bill Bergman, an insurance industry analyst with Morningstar Inc. said there is potential for the contracts to become more popular.

“It’s an exciting product that could fill a very substantial niche down the road,” said Bergman.

CME’s Stock Continues to Lag

admin — Tue, 02 Jun 2009 22:13:38 +0000

An interview with CME Group’s CEO Craig Donohue

While the problems wrought by the recession have hammered CME Group Inc.’s stock during the past year, the solutions being put forth to prevent future financial crises are starting to revive the share price.

CME could be the beneficiary of proposed government regulation that would push more trading onto its platforms. But just like the economy, the stock still has a long way to go to regain its former strength.In its trading pits and on its electronic platforms, hedgers and speculators alike are brought together by the CME to trade on the world’s largest futures and derivatives exchange. In late 2008 and early 2009, the global economic crisis drastically reduced CME’s trading volume and eroded its revenues, which it derives from the fees it charges per trade, and led to a decline its stock price.

The Chicago-based company’s stock has fallen 25.6 percent to $335.34 at the close of trade Tuesday from its 52-week high of $450.96 on June 17 and 52.2 percent below its peak of $701.78 on Dec. 12, 2007. The shares reached their 52-week low of $155.06 on Jan. 23.

The average daily volume of trades on CME’s platforms in May fell 14.7 percent compared with the same time period in 2008, with the company’s largest product line, interest rates derivatives, falling 28.7 percent last month from May of last year.

“The crisis has really had an effect on our interest rate products,” CME Chief Executive Officer Craig Donohue said at the annual shareholder meeting on May 13.

At the time, the Federal Reserve Board’s near zero interest rates had quashed volatility but in the last two weeks early signs of economic recovery and inflation fears have brought back interest rate volatility, increasing trading volume in that market 42.2 percent in May compared with April. Overall trading volume for the CME in May was up 16.8 percent from the previous month.

Mark Lane, an analyst with William Blair and Co. LLC, downgraded the stock in April to market perform from outperform. In an interview Tuesday, Lane said a recent spike in Treasury yields and investors willing to take on more risk have boosted trading volume, providing a “sign of light.” However, he said near-term growth remains under significant pressure.

”I think with volume growth, the comparisons will still be tough against last year,” Lane said.

However, Treasury Secretary Timothy Geithner proposed a plan to Congress May 13 that would mandate standardized derivatives contracts trade through regulated clearing houses such as CME. Since Geithner’s proposal was unveiled, shares of CME have rallied, increasing 29.7 percent in three weeks and soaring past the 52-week consensus price target of $245.88 compiled by Bloomberg LP.

“Pressure by the U.S. Treasury to clear trades could play to CME’s advantage,” Ken Worthington, an analyst for J.P. Morgan Chase and Co., said in a recent research note. He has a neutral rating on the stock and a 52-week price target of $280.

The primary benefit for CME under the Treasury’s plan would be increased volume on its over-the-counter platform Clearport, which it acquired when it bought the New York Mercantile Exchange in August.

One of the most high profile of the derivatives markets because of its role in the current financial crisis is the credit default swap market. Under Geithner’s plan, credit default swaps would likely be required to be traded on a regulated exchange like CME’s Clearport. However, despite CME gaining approval from the SEC in March to clear the products, it has yet to start doing so.

“It’s a lack of dealer support that’s keeping them out of that business,” Lane said.

Where the support has gone is to a major competitor to CME: IntercontinentalExchange Inc., which began trading credit default swaps in March. ICE has established a strong position in the market by clearing contracts totaling in excess of $350 billion in notional value, which is the total underlying worth of the contracts, not just the amount traders have paid to purchase the contracts themselves.

“Overall ICE has the advantage at the moment,” said Michael Wong, an analyst for Morningstar Inc., who has a three-out-of-five-star rating on CME’s stock and said its fair value was $236 prior to Geithner’s proposal. “They have more of the support of brokers and traders.”

Despite the attention it receives, CME CEO Donohue said there are bigger fish to fry in the OTC market than credit default swaps.

“Much has been talked about the credit default swaps market, which is currently about a $27 trillion market,” Donohue said. “But I think it’s important to see that the interest rates swaps market dwarfs that with roughly $300 trillion outstanding.”

It’s with the larger interest rate market, which could be pushed onto clearing services if Geithner’s plan is approved, where CME will regain the upper hand on ICE, analysts said.

“CME has a significant competitive advantage going after the interest swap market because it owns the interest rate futures market in the United States,” Lane said in a May 14 research note.

While new government regulations on the financial sector may fuel CME’s growth by increasing its trading volume and profits, for now, the company is trying to raise trading volume by introducing more product lines. Donahue said last year CME introduced 141 new products for Clearport and 100 more products for the OTC platform so far this year.

Shareholder Tully Davia, a retail investor, said he’s confident that CME’s research department will be active in developing new products that will fit both hedgers’ and speculators’ needs and also drive trading volume. He agrees with the company’s aggressive approach to continue rolling out more types of contracts to be traded on CME platforms.

“It’s the old ‘spaghetti against the wall’ approach,” said Davia. “If you list enough stuff, eventually something is going to stick.”